Chapter 1

introduced the transaction processing system (TPS) as an activity consisting of three major subsystems
called cycles: the revenue cycle, the expenditure cycle, and the conversion cycle. Even though each cycle
performs different specific tasks and supports different objectives, they share common characteristics.
For example, all three TPS cycles capture financial transactions, record the effects of transactions in
accounting records, and provide information about transactions to users in support of their day-to-day
activities. In addition, transaction cycles produce much of the raw data from which management reports
and financial statements are derived.Because of their financial impact on the firm, transaction cycles
command much of the accountant’s professional attention.

TPS applications process financial transactions.

A financial transaction was defined in Chapter 1 as An economic event that affects
the assets and equities of the firm, is reflected in its accounts, and is measured in
monetary terms. The most common financial transactions are economic
exchanges with external parties. These include the sale of goods or services, the
purchase of inventory, the discharge of financial obligations, and the receipt of
cash on account from customers. Financial transactions also include certain
internal events such as the depreciation of fixed assets; the application of labor,
raw materials, and overhead to the production process; and the transfer of
inventory from one department to another. Financial transactions are common
business events that occur regularly. For instance, thousands of transactions of a
particular type (sales to customers) may occur daily. To deal efficiently with such
volume, business firms group similar types of transactions into transaction cycles.
TRANSACTION CYCLES
Three transaction cycles process most of the firm’s economic activity: the
expenditure cycle, the conversion cycle, and the revenue cycle. These cycles exist
in all types of businesses both profit-seeking and not-for-profit types. For instance,
every business (1) incurs expenditures in exchange for resources (expenditure
cycle), (2) provides value added through its products or services (conversion
cycle), and (3) receives revenue from outside sources (revenue cycle). Figure 2-1
shows the relationship of these cycles and the resource flows between them.
The Expenditure Cycle
Business activities begin with the acquisition of materials, property, and labor in
exchange for cash—the expenditure cycle. Figure 2-1 shows the flow of cash from
the organization to the various providers of these resources. Most expenditure
transactions are based on a credit relationship between the trading parties. The
actual disbursement of cash takes place at some point after the receipt of the
goods or services. Days or even weeks may pass between these two events. Thus,
from a systems perspective, this transaction has two parts: a physical component
(the acquisition of the goods) and a financial component (the cash disbursement
to the supplier). A separate subsystem of the cycle processes each component.
The major subsystems of the expenditure cycle are outlined here. Because of the
extent of this body of material, two chapters are devoted to the expenditure
cycle.

 Purchases/accounts payable system

 Cash disbursements system
 Payroll system
 Fixed asset system

The Conversion Cycle

The conversion cycle is composed of two major subsystems: the production
system and the cost accounting system. The production system involves the
planning, scheduling, and control of the physical product through the
manufacturing process. This includes determining raw material requirements,
authorizing the work to be performed and the release of raw materials into
production, and directing the movement of the work-in-process through its
various stages of manufacturing. The cost accounting system monitors the flow of
cost information related to production. Information this system produces is used
for inventory valuation, budgeting, cost control, performance reporting, and
management decisions, such as make or-buy decisions. The conversion cycle is not
usually formal and observable in service and retailing establishments.
Nevertheless, these firms still engage in conversion cycle activities that culminate
in the development of a salable product or service. These activities include the
readying of products and services for market and the allocation of resources such
as depreciation, building amortization, and prepaid expenses to the proper
accounting period. However, unlike manufacturing firms, merchandising
companies do not process these activities through formal conversion cycle
subsystems.
The Revenue Cycle
Firms sell their finished goods to customers through the revenue cycle, which
involves processing cash sales, credit sales, and the receipt of cash following a
credit sale. Revenue cycle transactions also have a physical and a financial
component, which are processed separately. The primary subsystems of the
revenue cycle, which are the topics of Chapter 4, are briefly outlined below.
 Sales order processing
 Cash receipts

Accounting Records
MANUAL SYSTEMS
This section describes the purpose of each type of accounting record used in
transaction cycles. We begin with traditional records used in manual systems
(documents, journals, and ledgers) and then examine their magnetic counterparts
in computer-based systems.
Documents
A document provides evidence of an economic event and may be used to initiate
transaction processing.Some documents are a result of transaction processing. In
this section, we discuss three types of documents: source documents, product
documents, and turnaround documents.
SOURCE DOCUMENTS. Economic events result in some documents being created
at the beginning (the source) of the transaction. These are called source
documents. Source documents are used to capture and formalize transaction data
that the transaction cycle needs for processing. Figure 2-2 shows the creation of a
source document. The economic event (the sale) causes the sales clerk to prepare
a multipart sales order, which is formal evidence that a sale occurred. Copies of
this source document enter the sales system and are used to convey information
to various functions, such as billing, shipping, and AR. The information in the sales
order triggers specific activities in each of these departments.
PRODUCT DOCUMENTS.
Product documents are the result of transaction processing rather than the
triggering mechanism for the process. For example, a payroll check to an
employee is a product document of the payroll system. Figure 2-3 extends the
example in Figure 2-2 to illustrate that the customer’s bill is a product document
of the sales system. We will study many other examples of product documents in
later chapters.
TURNAROUND DOCUMENTS
. Turnaround documents are product documents of one system that become
source documents for another system. This is illustrated in Figure 2-4. The
customer receives a perforated two-part bill or statement. The top portion is the
actual bill, and the bottom portion is the remittance advice. Customers remove
the remittance advice and return it to the company along with their payment
(typically a check). A turnaround document contains important information about
a customer’s account to help the cash receipts system process the payment. One
of the problems designers of cash receipts systems face is matching customer
payments to the correct customer accounts.
Journals
A journal is a record of a chronological entry. At some point in the transaction
process, when all relevant facts about the transaction are known, the event is
recorded in a journal in chronological order. Documents are the primary source of
data for journals. Figure 2-5 shows a sales order being recorded in the sales
journal (see the following discussion on special journals).

SPECIAL JOURNALS
. Special journals are used to record specific classes of transactions that occur in
high volume. Such transactions can be grouped together in a special journal and
processed more efficiently than a general journal permits. Figure 2-6 shows a
special journal for recording sales transactions.
REGISTER. The term register is often used to denote certain types of special journals. For
example, the payroll journal is often called the payroll register. We also use the term
register, however, to denote a log. For example, a receiving register is a log of all receipts of
raw materials or merchandise ordered from vendors. Similarly, a shipping register is a log
that records all shipments to customers.

GENERAL JOURNALS. Firms use the general journal to record nonrecurring, infrequent,
and dissimilar transactions. For example, we usually record periodic depreciation and
closing entries in the general journal. Figure 2-7 shows one page from a general journal.
Note that the columns are nonspecific, allow- ing any type of transaction to be recorded.
The entries are recorded chronologically.

As a practical matter, most organizations have replaced their general journal with a journal
voucher system. A journal voucher is actually a special source document that contains a
single journal entry specifying the general ledger accounts that are affected. Journal
vouchers are used to record summaries of routine transactions, nonroutine transactions,
adjusting entries, and closing entries. The total of journal vouchers processed is equivalent
to the general journal. Subsequent chapters discuss the use of this technique in transaction
processing.

Ledgers
A ledger is a book of accounts that reflects the financial effects of the firm’s transactions
after they are posted from the various journals. Whereas journals show the chronological
effect of business activity, ledgers show activity by account type. A ledger indicates the
increases, decreases, and current balance of each account. Organizations use this
information to prepare financial statements, support daily operations, and prepare internal
reports. Figure 2-8 shows the flow of financial information from the source documents to the
journal and into the ledgers.
GENERAL LEDGERS. The general ledger (GL) summarizes the activity for each of
the organization’s accounts. The general ledger department updates these records
from journal vouchers prepared from special journals and other sources located
throughout the organization. The general ledger presented in Figure 2-9 shows
the beginning balances, the changes, and the ending balances as of a particular
date for several different accounts. reporting, but it is not useful for supporting
daily business operations. This value is obtained from the accounts receivable
control account in the general ledger. To actually collect the cash this asset
represents, however, the firm must have certain detailed information about the
customers that this summary figure does not provide. It must know which
customers owe money, how much each customer owes, when the customer last
made payment, when the next payment is due, and so on. The accounts
receivable subsidiary ledger contains these essential details.
SUBSIDIARY LEDGERS
. Subsidiary ledgers are kept in various accounting departments of the firm,
including inventory, accounts payable, payroll, and accounts receivable. This
separation provides better control and support of operations.
THE AUDIT TRAIL
The accounting records described previously provide an audit trail for tracing
transactions from source documents to the financial statements. Of the many
purposes of the audit trail, most important to accountants is the year-end audit.
Although the study of financial auditing falls outside the scope of this text, the
following thumbnail sketch of the audit process will demonstrate the importance
of the audit trail. The external auditor periodically evaluates the financial
statements of publicly held business organizations on behalf of its stockholders
and other interested parties. The auditor’s responsibility involves, in part, the
review of selected accounts and transactions to determine their validity, accuracy,
and completeness. Let’s assume an auditor wishes to verify the accuracy of a
client’s AR as published in its annual financial statements. The auditor can trace
the AR figure on the balance sheet to the general ledger AR control account. This
balance can then be reconciled with the total for the accounts receivable
subsidiary ledger. Rather than examining every transaction that affected the AR
account, the auditor will use a sampling technique to examine a representative
subset of transactions. This involves contacting selected customers to determine if
the transactions recorded in the accounts actually took place and that customers
agree with the recorded balance. Information contained in source documents and
subsidiary accounts enables the auditor to identify and locate customers chosen
for confirmation.

COMPUTER-BASED SYSTEMS
 Types of Files Audit trails in computer-based systems are less observable than in
traditional manual systems, but they still exist. Accounting records in computer-
based systems are represented by four different types of magnetic files: master
files, transaction files, reference files, and archive files. Figure 2-11 illustrates the
relationship of these files in forming an audit trail.
MASTER FILE. A master file generally contains account data. The general ledger
and subsidiary ledgers are examples of master files. Data values in master files are
updated from transactions.

TRANSACTION FILE. A transaction file is a temporary file of transaction records

used to change or update data in a master file. Sales orders, inventory receipts,
and cash receipts are examples of transaction files.
REFERENCE FILE. A reference file stores data that are used as standards for
processing transactions. For example, the payroll program may refer to a tax table
to calculate the proper amount of withholding taxes for payroll transactions.
Other reference files include price lists used for preparing customer in- voices, lists
of authorized suppliers, employee rosters, and customer credit files for approving
credit sales. The reference file in Figure 2-11 is a credit file.
ARCHIVE FILE. An archive file contains records of past transactions that are
retained for future reference. These transactions form an important part of the
audit trail. Archive files include journals, prior- period payroll information, lists of
former employees, records of accounts written off, and prior-period ledgers.